Google’s Hardware: Pain Now, Profit Later?

Google (NASDAQ:GOOG) just reported its Q3 earnings in a rather memorable fashion, and one of the day’s key takeaways was the increasing importance of mobile, including mobile advertising, to Google’s bottom line.

Another key point was the impact of Motorola. This was the first time Google included its recently acquired Motorola division in its earnings report — and the mobile device maker’s $527 million operating loss was partly to blame for the missed expectations. Google delivered a $2.18 billion profit, down from $2.73 billion the year before.

While yesterday’s events are unlikely to be repeated, investors should be prepared for a future where Google’s earnings aren’t quite so predictable as they once were. I wrote earlier about how hardware is likely to add an element of volatility to Google’s stock performance, and I think its Q3 earnings are a perfect example of that effect. Besides Motorola and its handsets, Google is pushing the Nexus 7 tablet, a new Chromebook and is presumably still tinkering with the infamous Nexus Q streaming media server.

Advertising revenue — which makes up the bulk of Google’s income — is highly unlikely to undergo dramatic quarterly swings. That’s a large part of what has made Google stock so attractive.

Hardware, however, is tougher to call. Development and manufacturing is expensive, inventory is costly and marketing can be a budget buster. Google can promote its search engine, online stores and other web-based products for “free” through its own network.

To get Motorola handsets in the hands of consumers requires paid advertising through a wide range of media. To promote its new $249 Chromebook, Google is reportedly expanding its bricks-and-mortar retail presence to 500 Best Buy (NYSE:BBY) stores, in kiosks staffed by Google-trained specialists. That’s the kind of expense that Google hasn’t had to worry about in the past.

Besides the manufacturing, inventory, distribution and promotional costs of hardware, consumers can be fickle. Apple (NASDAQ:AAPL) discovered that when sales of its iPhone 4S slowed dramatically as people held off buying in anticipation of the iPhone 5. Research In Motion (NASDAQ:RIMM) is a prime example of how quickly a company can see its fortunes reverse, even though it was a pioneer and — up until a few years ago — a leader, in a red-hot mobile market.

RIMM also provides a cautionary tale about the cost of hardware that consumers spurn: Its poorly received PlayBook tablet cost the company $1.5 billion it could ill afford to lose.

Google’s quarterly reports don’t break down specifics about revenue and costs for hardware product lines, but one way to get an idea of what’s going on there is to look at a section called “Other Cost of Revenues.” The cost to manufacture and sell those Nexus 7s and other hardware is buried in this category, which is described as: “data center operational expenses, amortization of intangible assets, content acquisition costs, credit card processing charges, and manufacturing and inventory-related costs [emphasis added].”

It’s tough to get too specific. For example, data center operational expenses are in there (that’s separate from data center infrastructure expenditures, which is accounted for separately under capital expenditures). But it’s a safe bet that manufacturing and inventory represent a good chunk of this category.

Let’s look at the numbers so far this year.

  • Q1: $1.28 billion (12% of revenue).
  • Q2: $2.41 billion (20% of revenue).
  • Q3: $3.78 billion (27% of revenue).

Again, because Google doesn’t break out the specifics, we can’t draw definitive conclusions from these numbers, but clearly, the trend shows that costs are mounting as a percentage of revenue. And given Google’s increasing focus on hardware this year, hardware is likely driving that increase.

Hardware can be immensely profitable when your devices are in demand (again, just look to Apple). However, besides having the associated costs, cyclical demand and consumer fickleness to contend with, Google has introduced another variable into the mix: selling hardware at a loss or breakeven level.

Apple commands high premiums for its products, but Google has pursued a strategy of practically giving away its hardware (with the exception of Motorola, of course). When the Nexus 7 tablet was released, Google was selling it at $199  — while components were estimated to cost $184, plus packaging, shipping and a free $25 Google Play credit that was included.

The reason Google is pursuing this low-cost strategy all rolls back to mobile. To gain ground in mobile advertising requires getting more Android devices into consumer hands and pushing Apple out of the picture. Gaining more revenue from its online stores — selling digital apps, movies, books and books — also depends on getting more Android devices out there (much like Amazon’s (NASDAQ:AMZN) strategy of selling Kindles cheap to gain future sales of digital content).

So, Google is willing to subsidize the hardware and forgo immediate profit in order to gain market share and future revenue. As Android becomes more popular as a platform, presumably Motorola’s premium-priced Android smartphones should also be become an easier sell.

While this fascination with hardware may seem like it’s outside of Google’s core competency, the strategy makes sense. However, as a result, investors need to be prepared for more ups and downs in Google earnings. Hardware and its associated costs may eat into revenue gains from advertising. And the positive effects of a device may not be felt directly (maybe even hurting the bottom line in a given quarter). But they could ultimately contribute to long-term revenue growth in other lines of business.

At least, that’s the hope.

As of this writing, Brad Moon doesn’t own any securities mentioned here. He is a paid contributor to Best Buy Canada’s Plug-in Blog.

Article printed from InvestorPlace Media,

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